Primer on interpreting hospital margins

Produced by the North Carolina Rural Health Research and Policy Analysis Center,
Cecil G. Sheps Center for Health Services Research, 725 Airport Road, CB#7590
The University of North Carolina at Chapel Hill, Chapel Hill, NC 27599-7590
http://www.shepscenter.unc.edu/research_programs/rural_program
A Primer on Interpreting
Hospital Margins
Background
Many rural hospitals, particularly small ones, have historically struggled to
survive financially. In order to develop policy regarding Medicare payment to
rural hospitals, it is often necessary for policy makers to evaluate current hospital
operating profitability. Analysts often utilize hospital margins as a measure of
rural hospital financial health, and the gap in average hospital margins between
urban and rural facilities is frequently referenced as an indicator of the need for
change to the Medicare payment system. In addition, simulations of predicted
margins are used as a tool to determine the relative utility of policies aimed at
providing relief to struggling rural facilities and to project the potential impact of
a proposed policy on future financial performance.
Policy decisions are sometimes made on the basis of average hospital margins,
aggregated across the industry or sub-groups of the industry, such as those based
on geographic urban or rural location or hospital size. Because there are a large
number of rural hospitals, each of which accounts for a relatively small amount of
Medicare expenditures, how average hospital margins are calculated can have an
impact on the perception of need for legislative and/or regulatory relief.
This Primer answers questions about the most commonly used measures of
over-all or payer-specific profitability, total margins and operating margins, and
addresses the different ways in which these measures are commonly aggregated
when they are used in descriptive studies or regulatory impact statements. The
measures are very similar, making it easy for policy analysts to overlook the slight
definitional differences when comparing study findings or recommendations from
different sources. If careful attention is not paid to the choice of the measures and
the method of aggregation, however, there is a risk of misinterpreting differences
across groups, or over- or under-interpreting trend data.
July 2003
What is the Definition of a Hospital Margin?
A hospital margin is the ratio of hospital profits to hospital revenue. There are two
different margins that are frequently used as measures of over-all profitability in
health care: (1) total margin, and (2) operating margin. “Total margin” expresses the
difference between total revenue and costs as a proportion of total revenue. Included
in revenue in the total margin is “non-operating income” — that is, revenue from
contributions, public appropriation and other government transfers, investments, and
income from subsidiaries or affiliates. When a hospital’s margin is computed only
with revenues and costs related to patient care, it is usually called an “operating
margin”, which expresses the difference between operating revenue and costs as a
proportion of operating revenue. In most business settings, the numerators in both
ratios would be referred to as a “before-tax profit,” but in the language of
government and non-profit entities, it is referred to simply as “net income,” or, more
formally, as “the surplus of revenue over expenses”.
(1) Total Margins:
(2) Operating Margins:
For each of these measures respectively, the ratio will be positive if the facility has a
total or operating profit, zero if it is at break-even and negative if it has a total or
operating loss (it is assumed that a facility does not have negative operating
revenue). The ratio is often expressed as a percent: a hospital with total profits of
$5 million earned on $100 million of revenue would have a 5% total margin.
How Do Operating and Total Margins Relate to Each Other?
The median values for both operating and total margins for acute care hospitals in
the U.S. for the federal reporting periods 1996 through 1999 are shown in Figure 1.
Although both margins tend to move in similar directions over time, they each
measure slightly different
things. For example,
median operating margins
(the bottom line in Figure 1)
were negative in three of the
four years, indicating that more
than half the hospitals were
operating at a loss. However,
for these same years, the median
total margins were positive
(top line), showing that many of
the hospitals that lost money on
operations were able to make up
their losses through other
sources of support.
total revenue - total cost
total revenue
operating revenue - operating cost
operating revenue
A Primer on Interpreting Hospital Margins
-4%
-2%
0%
2%
4%
6%
1996 1997 1998 1999
o
total margin operating margin
Federal Reporting Year
Source: Author’s computation from HCRIS reports, FY 1996—FY 1999.
Figure 1: Median Values of Total
and Operating Margins Over Time
(as Reported by Participating Medicare Acute-Care Hospitals)
2
Which Margin Should be Used to Evaluate Hospital Performance?
While both operating and total margins can be found in policy analyses, and the
ratios are similar in construction, they are not interchangeable. One measure may be
more appropriate than the other, depending on the objective of the study.
Some public hospitals rely extensively on government transfers that will not factor
into the calculation of the operating margin. If public monies are offered only
sporadically (for example, in varying amounts that are intended to support a facility
through a difficult year), then the operating margin will be a good indicator of that
hospital’s expected financial performance. If, however, the appropriation is a regular,
budgeted item (for example, a stable source of funding to offset indigent care
write-offs), then the hospital’s price structure probably reflects this other source of
revenue. The operating margin, computed without this income, will appear low or
even negative, and will give a distorted picture of the expected performance and
general financial health of the institution.
What is a Payer-Specific Margin?
In order to assess whether a program is reimbursing hospitals adequately, regulatory
analyses and rate studies frequently focus on margins attributable to a specific payer
group, such as Medicare or Medicaid. Total margins cannot be meaningfully
computed for a single payer group, since by definition, they include non-operating
revenue, which cannot come from an insurer. It is possible to compute operating
margins based on the payments and estimated costs of patients insured by a specific
payer, provided that there is a standardized method for apportioning costs to one
patient over another. The Centers for Medicare and Medicaid Services (CMS), the
Medicare Payment Advisory Commission (MedPAC) and several other federal and
congressional agencies frequently compute Medicare margins in the course of
evaluating rates under Medicare’s various prospective payment systems (PPS). These
margins are based on the data from annual cost reports that are filed by hospitals,
nursing homes, clinics and home health agencies. Payer-specific measures are also
computed for other non-government programs, but they are less common because it
is difficult to estimate payer-specific costs.
Why Do Different Analysts Sometimes Produce Different Estimates of the
Average Margin for the Same Group of Hospitals in a Given Year?
Margins are frequently aggregated across hospital groups, or from year to year.
Percentile distributions and simple averages are the most common ways of
summarizing these data. The 25th, 50th or 75th percentile of a given measure is fairly
easy to compute, present and interpret, but averages are not as straightforward.
Because margins are ratios of two values, what is labeled as an average may be the
simple arithmetic mean of the individual ratios of facilities within the group, or it
may be an aggregate measure that is a ratio of the sums of the original information
that went into the margin.
Often, the difference between these two types of averages is not properly
documented in published tables, but there can be a very important distinction: when
we compute a simple average of any given profitability ratio, a small facility will have
as much influence as a large one on the final average. In contrast, an aggregate ratio
A Primer on Interpreting Hospital Margins
3
(which is computed from the sum of all the information in the numerator divided by
the sum of all the information in the denominator) is effectively a weighted average;
therefore, the hospitals with larger denominators will have more influence on the
resulting summary measure. Figure 2 provides a simple example of this for PPS
operating margins, using hypothetical information for four hospitals of varying size
with different levels of profit or loss.
In this example, the large hospital has much better profitability than the three smaller
ones, so the aggregate ratio is higher than the simple average of the ratios. The two
methods of calculating average margins would only result in similar values if small
facilities tended to have the same margins as large ones, or if all facilities were the
same size. However, among U.S. hospitals, there are many more small facilities than
large ones, and these smaller facilities tend to have lower inpatient PPS margins.
How Much Difference Does the Method Used to Calculate
Average Margins Make?
The method used to calculate average margins makes quite a bit of difference when
comparing urban/rural differences in profitability, as the gap between a hospital
group average margin (that is a simple average) and one that is an aggregate ratio
average (effectively, a dollar-weighted
average) can be
substantial. The average
difference between urban and
rural hospitals based on the
aggregate average ratio is
much more striking than the
difference based on the simple
average (Table 1). To the extent
that hospitals within the
subgroups are more similar in
size, there will be less
difference between the two
averaging methods for any
A Primer on Interpreting Hospital Margins
Median (50th
Percentile)
Simple
Average
PPS Margin
Aggregate
Average
PPS Margin
Rural Hospitals 2.6% 1.6% 3.6%
Urban (MSA) Hospitals 9.7% 8.7% 13.3%
All Hospitals 6.6% 5.6% 12.0%
Source: Author’s computations from HCRIS Reports, FY 1999.
4
Figure 2.
Table 1: What’s the Difference?
Comparing Simple Average to Aggregate Average
Medicare PPS Operating Margins
given group. However, for urban and rural subgroups, and for all hospitals as a
group, the aggregate average inpatient PPS margin has always been higher than the
simple average, with the median falling somewhere in between.
Figure 3 provides another example, looking at changes for all acute care hospitals
over time. Using the aggregate ratio, margins declined by 21% from 1996 to 1999.
Using the simple average
across hospitals, the margins
declined by 47%.
Which Average Margin is
Better to Use, the Simple or
the Aggregate?
Which margin is the right one
to use depends on the under-lying
question to be
addressed. The aggregate
margin would always be
more appropriate for under-standing
the total budget
impact of program changes.
MedPAC routinely uses
aggregate average ratios to
summarize Medicare margins
in their annual reports to
Congress, and this is the appropriate measure when the policy question of interest is
related to overall Medicare spending. A simple average might be better to identify
the impact of program changes across individual hospitals. But, neither measure tells
us how margins are distributed across hospitals, or what proportion of hospitals is
losing money. As was seen in the example in Figure 2, both the aggregate and simple
average margins were positive, but only two of the four hypothetical hospitals were
actually profitable. When the policy questions relate to concerns about the
distribution of margins across facilities, CMS and MedPAC usually report percentile
distributions, or they present the aggregated margins by subgroups of hospitals (for
example, by teaching status, bed size or urban/rural location).
When Interpreting Hospital Margins, What is Revenue and What is Cost?
Margins computed for individual payer groups warrant close scrutiny for other
reasons, having to do with how payer payments and payer costs are defined. Rate
analysts generally define payments as the total amount that should be received for
the service, assuming that the parts that are the patients’ responsibility are collected
in full. From a regulatory or rate-setting perspective this is appropriate, because
whether coinsurance and deductibles can be collected is a separate policy issue from
rate adequacy. By convention, the Medicare margins follow this line of thinking and
treat ALL patient balances as if they are or will be fully collected. The convention has
merit if the purpose of payer-specific margins is, for example, to evaluate the
adequacy of Medicare rates, but not if the purpose is to evaluate the industry’s losses
on a specific group of patients. Medicare coinsurance and deductible amounts often
A Primer on Interpreting Hospital Margins
-10%
-5%
0%
5%
10%
15%
20%
1992 1993 1994 1995 1996 1997 1998 1999
Federal Fiscal Year
Simple Average Aggregate Ratio
Source: Author’s computations from HCRIS Reports, FY 1992—FY 1999.
Figure 3: Inpatient Medicare
PPS Operating Margins, by Year
5
have to be written off, and since the Balanced Budget Act of 1997, the Medicare
program reimburses providers for only a portion of write-offs attributable to these
patient balances.
Definitional problems on the cost side are even more complex. First of all, standard
financial accounting reports are designed to identify expenses by type—such as
salaries, supplies, or equipment depreciation—but not necessarily by product.
Additional cost accounting procedures are necessary for a facility to identify the cost
of a particular service that can then be matched to a particular payment. Federally
mandated cost reports follow specific rules to allocate administrative and other
indirect costs to each patient care service area, and then apportion the allocated
service-specific costs to Medicare and Medicaid patients based on the filed claims
data. A payer-specific margin computed for other third party payers may not have
followed the same cost allocation or apportionment procedures. Comparing ratios
from one payer to another may be misleading.
In addition, when evaluating Medicare and Medicaid measures, it is important to
know that the programs disallow certain types of costs, such as marketing or
professional salaries that exceed regulatory limits, and that these amounts are simply
adjusted off the cost reports as if they were not incurred. In most cases, the amounts
are not big enough to alter a margin by much, but for some institutions, the effect
could be substantial. A more important disallowance that occurs for all hospitals is
the set of statutory outpatient cost reductions. These are across-the-board reductions
in the computed outpatient costs that have been a part of the regulations governing
the outpatient cost-based payments since the late 1980s. When federal agencies
compute margins, they usually add back these statutory reductions, but other
investigators may not be familiar enough with cost reports to know how to adjust
the data.
The statutory reductions on outpatient costs arose from a more complicated problem
that should be taken into account whenever Medicare margins are computed for one
type of service, but not for all. Medicare has had a prospective payment system in
place for inpatient care for nearly 20 years, but it continued to provide some cost-based
reimbursement for outpatient services until 1999. Cost analysts generally
believe that hospitals had an incentive to maximize reimbursement by allocating
more overhead costs to outpatient areas. As a result, inpatient margins are thought
to be overstated (as compared to what they would have been in the absence of
reimbursement incentives) because correspondingly less overhead may have been
allocated to inpatient service areas. The outpatient cost reductions were put in place
in part to counteract this, although there is little empirical evidence to support the
actual level of the reductions. The statutorily reduced costs were used to compute the
average costs per unit of service that serve as a basis for the new rates under
outpatient PPS. Thus, artificially low outpatient margins are built into the new
payment system.1
6
A Primer on Interpreting Hospital Margins
1 Using a similar argument about inflated hospital overhead, the new prospective rates for skilled
nursing and home health services were set to reflect expected average costs after down-weighting the
pool of costs contributed by hospital-based units.
With so much program-to-program distortion designed into the different PPS rates,
an accurate measure of hospitals’ Medicare profitability can only be obtained if the
payments and costs of all of the Medicare services are combined. Recognizing this,
MedPAC has begun including an overall Medicare margin in its reports to Congress
for the past three years, but the data and procedures for these estimates are more
complicated than those for the inpatient margins. There are some Medicare services
that are paid on fixed fee schedules (such as outpatient diagnostic lab and durable
medical equipment) that never appear on the cost reports, and for which no national
data are available. The fee-based payments are well below cost for hospital lab
services, and outpatient diagnostic lab services often make up a disproportionately
large share of business in small rural facilities. It is likely, therefore, that the overall
Medicare margin estimates systematically overstate the ratios for smaller rural
hospitals, since services on which they typically lose money (and disproportionately
rely on) are not included in the calculation.
What Other Measures Do Policy Analysts Use to Determine Hospital Profitability?
Although not seen as frequently as hospital margins, another payer-specific measure
of hospital profitability that is found in the policy literature is the payment-to-cost
ratio.
(3) Payment-to-cost ratio
(usually payer-specific):
Payment-to-cost ratios are rarely used to analyze overall performance, but are often
applied for payer-specific studies. The payment-to-cost ratio is derived from the
same information as the operating margin, but it expresses payments relative to cost
rather than relative to income. For example, payments of $1.15 million for services
costing $1 million would have a payment-to-cost ratio of 1.15, or 115%. The value is
greater than one if the facility has a profit, equal to one if it is operating at break-even
(because payments equal cost), and between zero and one if it is operating at a loss.
It would not normally ever be negative, since neither revenues nor expenses are
expected to be negative. If you were to subtract one from the payment ratio, this
measure would be equivalent to expressing profit as a proportion of costs, and the
scale would be similar to that of the traditional margin. Payment ratios may be
somewhat more intuitive to rate and budget analysts, especially those studying
health care sectors that were once operated under retrospective cost-based
reimbursement, while Margins are the more widely accepted measure in business
finance and academic studies.2
patient payments
patient cost
7
A Primer on Interpreting Hospital Margins
2 The choice of expressing profits relative to revenue or profits relative to costs relates to a more basic
issue rooted in notions of market-driven versus regulated prices. In micro-economic theory, prices are
assumed to be determined in the market place, and so are independent of any individual facility’s
costs. Thus, to assess a facility’s performance, we would want to express profit relative to this
independent, or externally determined, measure. In a rate-setting environment, government-administered
prices are the item that is being determined, while—in the short run, at least—facilities’
costs are treated as the independent item. To evaluate a particular payment scheme, therefore,
analysts would compare financial performance under alternative rates, and so would want to consider
profits relative to the externally-determined costs.
This work is funded by the Federal Office of Rural Health Policy
under cooperative agreement # 6 UIC RH 00027-03.
For more information, contact Kathleen Dalton or Rebecca Slifkin at : (919) 966-5541.
Other recent publications available from the North Carolina Rural Health Research and Policy
Analysis Center include:
Unstable Demand and Cost per Case in Low-Volume Hospitals
Unpredictable Demand and Low-Volume Hospitals
Rural Populations and Health Care Providers: A Mapbook
Design of Enhanced Primary Care Management Programs Operating in Rural
Communities: Lessons Learned from Three States
■
■
■
■
North Carolina Rural Health Research and Policy Analysis Center
Cecil G. Sheps Center for Health Services Research
CB#7590, 725 Airport Road
University of North Carolina at Chapel Hill
Chapel Hill, NC 27599-7590

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Produced by the North Carolina Rural Health Research and Policy Analysis Center,
Cecil G. Sheps Center for Health Services Research, 725 Airport Road, CB#7590
The University of North Carolina at Chapel Hill, Chapel Hill, NC 27599-7590
http://www.shepscenter.unc.edu/research_programs/rural_program
A Primer on Interpreting
Hospital Margins
Background
Many rural hospitals, particularly small ones, have historically struggled to
survive financially. In order to develop policy regarding Medicare payment to
rural hospitals, it is often necessary for policy makers to evaluate current hospital
operating profitability. Analysts often utilize hospital margins as a measure of
rural hospital financial health, and the gap in average hospital margins between
urban and rural facilities is frequently referenced as an indicator of the need for
change to the Medicare payment system. In addition, simulations of predicted
margins are used as a tool to determine the relative utility of policies aimed at
providing relief to struggling rural facilities and to project the potential impact of
a proposed policy on future financial performance.
Policy decisions are sometimes made on the basis of average hospital margins,
aggregated across the industry or sub-groups of the industry, such as those based
on geographic urban or rural location or hospital size. Because there are a large
number of rural hospitals, each of which accounts for a relatively small amount of
Medicare expenditures, how average hospital margins are calculated can have an
impact on the perception of need for legislative and/or regulatory relief.
This Primer answers questions about the most commonly used measures of
over-all or payer-specific profitability, total margins and operating margins, and
addresses the different ways in which these measures are commonly aggregated
when they are used in descriptive studies or regulatory impact statements. The
measures are very similar, making it easy for policy analysts to overlook the slight
definitional differences when comparing study findings or recommendations from
different sources. If careful attention is not paid to the choice of the measures and
the method of aggregation, however, there is a risk of misinterpreting differences
across groups, or over- or under-interpreting trend data.
July 2003
What is the Definition of a Hospital Margin?
A hospital margin is the ratio of hospital profits to hospital revenue. There are two
different margins that are frequently used as measures of over-all profitability in
health care: (1) total margin, and (2) operating margin. “Total margin” expresses the
difference between total revenue and costs as a proportion of total revenue. Included
in revenue in the total margin is “non-operating income” — that is, revenue from
contributions, public appropriation and other government transfers, investments, and
income from subsidiaries or affiliates. When a hospital’s margin is computed only
with revenues and costs related to patient care, it is usually called an “operating
margin”, which expresses the difference between operating revenue and costs as a
proportion of operating revenue. In most business settings, the numerators in both
ratios would be referred to as a “before-tax profit,” but in the language of
government and non-profit entities, it is referred to simply as “net income,” or, more
formally, as “the surplus of revenue over expenses”.
(1) Total Margins:
(2) Operating Margins:
For each of these measures respectively, the ratio will be positive if the facility has a
total or operating profit, zero if it is at break-even and negative if it has a total or
operating loss (it is assumed that a facility does not have negative operating
revenue). The ratio is often expressed as a percent: a hospital with total profits of
$5 million earned on $100 million of revenue would have a 5% total margin.
How Do Operating and Total Margins Relate to Each Other?
The median values for both operating and total margins for acute care hospitals in
the U.S. for the federal reporting periods 1996 through 1999 are shown in Figure 1.
Although both margins tend to move in similar directions over time, they each
measure slightly different
things. For example,
median operating margins
(the bottom line in Figure 1)
were negative in three of the
four years, indicating that more
than half the hospitals were
operating at a loss. However,
for these same years, the median
total margins were positive
(top line), showing that many of
the hospitals that lost money on
operations were able to make up
their losses through other
sources of support.
total revenue - total cost
total revenue
operating revenue - operating cost
operating revenue
A Primer on Interpreting Hospital Margins
-4%
-2%
0%
2%
4%
6%
1996 1997 1998 1999
o
total margin operating margin
Federal Reporting Year
Source: Author’s computation from HCRIS reports, FY 1996—FY 1999.
Figure 1: Median Values of Total
and Operating Margins Over Time
(as Reported by Participating Medicare Acute-Care Hospitals)
2
Which Margin Should be Used to Evaluate Hospital Performance?
While both operating and total margins can be found in policy analyses, and the
ratios are similar in construction, they are not interchangeable. One measure may be
more appropriate than the other, depending on the objective of the study.
Some public hospitals rely extensively on government transfers that will not factor
into the calculation of the operating margin. If public monies are offered only
sporadically (for example, in varying amounts that are intended to support a facility
through a difficult year), then the operating margin will be a good indicator of that
hospital’s expected financial performance. If, however, the appropriation is a regular,
budgeted item (for example, a stable source of funding to offset indigent care
write-offs), then the hospital’s price structure probably reflects this other source of
revenue. The operating margin, computed without this income, will appear low or
even negative, and will give a distorted picture of the expected performance and
general financial health of the institution.
What is a Payer-Specific Margin?
In order to assess whether a program is reimbursing hospitals adequately, regulatory
analyses and rate studies frequently focus on margins attributable to a specific payer
group, such as Medicare or Medicaid. Total margins cannot be meaningfully
computed for a single payer group, since by definition, they include non-operating
revenue, which cannot come from an insurer. It is possible to compute operating
margins based on the payments and estimated costs of patients insured by a specific
payer, provided that there is a standardized method for apportioning costs to one
patient over another. The Centers for Medicare and Medicaid Services (CMS), the
Medicare Payment Advisory Commission (MedPAC) and several other federal and
congressional agencies frequently compute Medicare margins in the course of
evaluating rates under Medicare’s various prospective payment systems (PPS). These
margins are based on the data from annual cost reports that are filed by hospitals,
nursing homes, clinics and home health agencies. Payer-specific measures are also
computed for other non-government programs, but they are less common because it
is difficult to estimate payer-specific costs.
Why Do Different Analysts Sometimes Produce Different Estimates of the
Average Margin for the Same Group of Hospitals in a Given Year?
Margins are frequently aggregated across hospital groups, or from year to year.
Percentile distributions and simple averages are the most common ways of
summarizing these data. The 25th, 50th or 75th percentile of a given measure is fairly
easy to compute, present and interpret, but averages are not as straightforward.
Because margins are ratios of two values, what is labeled as an average may be the
simple arithmetic mean of the individual ratios of facilities within the group, or it
may be an aggregate measure that is a ratio of the sums of the original information
that went into the margin.
Often, the difference between these two types of averages is not properly
documented in published tables, but there can be a very important distinction: when
we compute a simple average of any given profitability ratio, a small facility will have
as much influence as a large one on the final average. In contrast, an aggregate ratio
A Primer on Interpreting Hospital Margins
3
(which is computed from the sum of all the information in the numerator divided by
the sum of all the information in the denominator) is effectively a weighted average;
therefore, the hospitals with larger denominators will have more influence on the
resulting summary measure. Figure 2 provides a simple example of this for PPS
operating margins, using hypothetical information for four hospitals of varying size
with different levels of profit or loss.
In this example, the large hospital has much better profitability than the three smaller
ones, so the aggregate ratio is higher than the simple average of the ratios. The two
methods of calculating average margins would only result in similar values if small
facilities tended to have the same margins as large ones, or if all facilities were the
same size. However, among U.S. hospitals, there are many more small facilities than
large ones, and these smaller facilities tend to have lower inpatient PPS margins.
How Much Difference Does the Method Used to Calculate
Average Margins Make?
The method used to calculate average margins makes quite a bit of difference when
comparing urban/rural differences in profitability, as the gap between a hospital
group average margin (that is a simple average) and one that is an aggregate ratio
average (effectively, a dollar-weighted
average) can be
substantial. The average
difference between urban and
rural hospitals based on the
aggregate average ratio is
much more striking than the
difference based on the simple
average (Table 1). To the extent
that hospitals within the
subgroups are more similar in
size, there will be less
difference between the two
averaging methods for any
A Primer on Interpreting Hospital Margins
Median (50th
Percentile)
Simple
Average
PPS Margin
Aggregate
Average
PPS Margin
Rural Hospitals 2.6% 1.6% 3.6%
Urban (MSA) Hospitals 9.7% 8.7% 13.3%
All Hospitals 6.6% 5.6% 12.0%
Source: Author’s computations from HCRIS Reports, FY 1999.
4
Figure 2.
Table 1: What’s the Difference?
Comparing Simple Average to Aggregate Average
Medicare PPS Operating Margins
given group. However, for urban and rural subgroups, and for all hospitals as a
group, the aggregate average inpatient PPS margin has always been higher than the
simple average, with the median falling somewhere in between.
Figure 3 provides another example, looking at changes for all acute care hospitals
over time. Using the aggregate ratio, margins declined by 21% from 1996 to 1999.
Using the simple average
across hospitals, the margins
declined by 47%.
Which Average Margin is
Better to Use, the Simple or
the Aggregate?
Which margin is the right one
to use depends on the under-lying
question to be
addressed. The aggregate
margin would always be
more appropriate for under-standing
the total budget
impact of program changes.
MedPAC routinely uses
aggregate average ratios to
summarize Medicare margins
in their annual reports to
Congress, and this is the appropriate measure when the policy question of interest is
related to overall Medicare spending. A simple average might be better to identify
the impact of program changes across individual hospitals. But, neither measure tells
us how margins are distributed across hospitals, or what proportion of hospitals is
losing money. As was seen in the example in Figure 2, both the aggregate and simple
average margins were positive, but only two of the four hypothetical hospitals were
actually profitable. When the policy questions relate to concerns about the
distribution of margins across facilities, CMS and MedPAC usually report percentile
distributions, or they present the aggregated margins by subgroups of hospitals (for
example, by teaching status, bed size or urban/rural location).
When Interpreting Hospital Margins, What is Revenue and What is Cost?
Margins computed for individual payer groups warrant close scrutiny for other
reasons, having to do with how payer payments and payer costs are defined. Rate
analysts generally define payments as the total amount that should be received for
the service, assuming that the parts that are the patients’ responsibility are collected
in full. From a regulatory or rate-setting perspective this is appropriate, because
whether coinsurance and deductibles can be collected is a separate policy issue from
rate adequacy. By convention, the Medicare margins follow this line of thinking and
treat ALL patient balances as if they are or will be fully collected. The convention has
merit if the purpose of payer-specific margins is, for example, to evaluate the
adequacy of Medicare rates, but not if the purpose is to evaluate the industry’s losses
on a specific group of patients. Medicare coinsurance and deductible amounts often
A Primer on Interpreting Hospital Margins
-10%
-5%
0%
5%
10%
15%
20%
1992 1993 1994 1995 1996 1997 1998 1999
Federal Fiscal Year
Simple Average Aggregate Ratio
Source: Author’s computations from HCRIS Reports, FY 1992—FY 1999.
Figure 3: Inpatient Medicare
PPS Operating Margins, by Year
5
have to be written off, and since the Balanced Budget Act of 1997, the Medicare
program reimburses providers for only a portion of write-offs attributable to these
patient balances.
Definitional problems on the cost side are even more complex. First of all, standard
financial accounting reports are designed to identify expenses by type—such as
salaries, supplies, or equipment depreciation—but not necessarily by product.
Additional cost accounting procedures are necessary for a facility to identify the cost
of a particular service that can then be matched to a particular payment. Federally
mandated cost reports follow specific rules to allocate administrative and other
indirect costs to each patient care service area, and then apportion the allocated
service-specific costs to Medicare and Medicaid patients based on the filed claims
data. A payer-specific margin computed for other third party payers may not have
followed the same cost allocation or apportionment procedures. Comparing ratios
from one payer to another may be misleading.
In addition, when evaluating Medicare and Medicaid measures, it is important to
know that the programs disallow certain types of costs, such as marketing or
professional salaries that exceed regulatory limits, and that these amounts are simply
adjusted off the cost reports as if they were not incurred. In most cases, the amounts
are not big enough to alter a margin by much, but for some institutions, the effect
could be substantial. A more important disallowance that occurs for all hospitals is
the set of statutory outpatient cost reductions. These are across-the-board reductions
in the computed outpatient costs that have been a part of the regulations governing
the outpatient cost-based payments since the late 1980s. When federal agencies
compute margins, they usually add back these statutory reductions, but other
investigators may not be familiar enough with cost reports to know how to adjust
the data.
The statutory reductions on outpatient costs arose from a more complicated problem
that should be taken into account whenever Medicare margins are computed for one
type of service, but not for all. Medicare has had a prospective payment system in
place for inpatient care for nearly 20 years, but it continued to provide some cost-based
reimbursement for outpatient services until 1999. Cost analysts generally
believe that hospitals had an incentive to maximize reimbursement by allocating
more overhead costs to outpatient areas. As a result, inpatient margins are thought
to be overstated (as compared to what they would have been in the absence of
reimbursement incentives) because correspondingly less overhead may have been
allocated to inpatient service areas. The outpatient cost reductions were put in place
in part to counteract this, although there is little empirical evidence to support the
actual level of the reductions. The statutorily reduced costs were used to compute the
average costs per unit of service that serve as a basis for the new rates under
outpatient PPS. Thus, artificially low outpatient margins are built into the new
payment system.1
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A Primer on Interpreting Hospital Margins
1 Using a similar argument about inflated hospital overhead, the new prospective rates for skilled
nursing and home health services were set to reflect expected average costs after down-weighting the
pool of costs contributed by hospital-based units.
With so much program-to-program distortion designed into the different PPS rates,
an accurate measure of hospitals’ Medicare profitability can only be obtained if the
payments and costs of all of the Medicare services are combined. Recognizing this,
MedPAC has begun including an overall Medicare margin in its reports to Congress
for the past three years, but the data and procedures for these estimates are more
complicated than those for the inpatient margins. There are some Medicare services
that are paid on fixed fee schedules (such as outpatient diagnostic lab and durable
medical equipment) that never appear on the cost reports, and for which no national
data are available. The fee-based payments are well below cost for hospital lab
services, and outpatient diagnostic lab services often make up a disproportionately
large share of business in small rural facilities. It is likely, therefore, that the overall
Medicare margin estimates systematically overstate the ratios for smaller rural
hospitals, since services on which they typically lose money (and disproportionately
rely on) are not included in the calculation.
What Other Measures Do Policy Analysts Use to Determine Hospital Profitability?
Although not seen as frequently as hospital margins, another payer-specific measure
of hospital profitability that is found in the policy literature is the payment-to-cost
ratio.
(3) Payment-to-cost ratio
(usually payer-specific):
Payment-to-cost ratios are rarely used to analyze overall performance, but are often
applied for payer-specific studies. The payment-to-cost ratio is derived from the
same information as the operating margin, but it expresses payments relative to cost
rather than relative to income. For example, payments of $1.15 million for services
costing $1 million would have a payment-to-cost ratio of 1.15, or 115%. The value is
greater than one if the facility has a profit, equal to one if it is operating at break-even
(because payments equal cost), and between zero and one if it is operating at a loss.
It would not normally ever be negative, since neither revenues nor expenses are
expected to be negative. If you were to subtract one from the payment ratio, this
measure would be equivalent to expressing profit as a proportion of costs, and the
scale would be similar to that of the traditional margin. Payment ratios may be
somewhat more intuitive to rate and budget analysts, especially those studying
health care sectors that were once operated under retrospective cost-based
reimbursement, while Margins are the more widely accepted measure in business
finance and academic studies.2
patient payments
patient cost
7
A Primer on Interpreting Hospital Margins
2 The choice of expressing profits relative to revenue or profits relative to costs relates to a more basic
issue rooted in notions of market-driven versus regulated prices. In micro-economic theory, prices are
assumed to be determined in the market place, and so are independent of any individual facility’s
costs. Thus, to assess a facility’s performance, we would want to express profit relative to this
independent, or externally determined, measure. In a rate-setting environment, government-administered
prices are the item that is being determined, while—in the short run, at least—facilities’
costs are treated as the independent item. To evaluate a particular payment scheme, therefore,
analysts would compare financial performance under alternative rates, and so would want to consider
profits relative to the externally-determined costs.
This work is funded by the Federal Office of Rural Health Policy
under cooperative agreement # 6 UIC RH 00027-03.
For more information, contact Kathleen Dalton or Rebecca Slifkin at : (919) 966-5541.
Other recent publications available from the North Carolina Rural Health Research and Policy
Analysis Center include:
Unstable Demand and Cost per Case in Low-Volume Hospitals
Unpredictable Demand and Low-Volume Hospitals
Rural Populations and Health Care Providers: A Mapbook
Design of Enhanced Primary Care Management Programs Operating in Rural
Communities: Lessons Learned from Three States
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North Carolina Rural Health Research and Policy Analysis Center
Cecil G. Sheps Center for Health Services Research
CB#7590, 725 Airport Road
University of North Carolina at Chapel Hill
Chapel Hill, NC 27599-7590